Which Tax Minimization Strategy Should You Use?

Tax avoidance is one of those controversial issues in which everyone has an opinion. Several studies have indicated that opinions on such an issue heavily depend on one’s preferred political ideology, views on corporate ethics and social responsibility, as well as psychological traits. Building a tax minimization strategy is perfectly legal, especially during this COVID-19 pandemic period, which has brought undue economic hardships and restrictions, globally. In this article, you can find a comprehensive list of tax planning strategies, as well as the pros and cons of adhering to such.

Tax Minimization

The tax minimization definition is the legitimate usage of various means to reduce the amount of income tax—sometimes in a way that the government has not intended. Through tax minimization, individuals and corporations can reap the benefits of tax planning by employing innovative income tax strategies. This, however, is usually perceived as an immoral thing to do. To illustrate, consider the purpose of paying taxes. There are three kinds of taxes in the US: federal, state, and local. On the federal level, tax dollars are provided for Social Security, Medicare, and for such agencies as Homeland Security and the Department of Veterans Affairs, as well as other welfare programs. On the state and local level, all levels of education, hospitals, road infrastructure, and police are supported by the tax dollars. This is why avoiding paying taxes is often perceived as circumventing social obligations and, in the case of corporations, encouraging greed and selfishness.

How Does Tax Minimization Work?

Tax avoidance is not the same as tax evasion. While the latter is rightly deemed unethical and illegal, legal tax avoidance is guaranteed by the US Supreme Court.

Many have questions as to how to avoid paying taxes legally. Two ways to avoid or minimize taxes are by:

  1. Tax planning or tax mitigation
  2. Loopholes in the law

High-income tax shelters (offshore companies, financing arrangements, investments) are among the most popular means of minimizing taxes for companies wanting to avoid or evade paying taxes. The careful balance of income deferral, income splitting, or investments is the road most often traveled by ordinary people looking to save money. If you’re interested in paying fewer taxes, you don’t need to consult tax planning experts to implement our tips to reduce taxes; instead, save more money by doing your own taxes.

Tax Planning Strategies

The income tax system in the US is progressive, which means that taxpayers who have higher incomes are listed in a higher tax bracket, thereby reducing tax burdens on those who earn significantly less.

Each tax bracket is accordingly taxed to the amount of income limited to that bracket. Although, for example, there were 16 different tax brackets in 1985, only seven were selected by the IRS during this pandemic-afflicted year. Tax brackets, however, not only detail tax rates but also filing status, which is tightly connected to marital status. For instance, if you are a single filer, you would have lower income limits for most exemptions. In contrast, married couples can jointly file their taxes, which results in lower tax liability.

It’s important to familiarize yourself with the different aspects of tax plan deductions, tax credits, standard deductions, and itemizing (seen in the table below):

Tax credit Tax deduction Standard deduction Itemizing
What is it? Dollar-for-dollar reduction of your tax liability. General term denoting how much of your income is subject to taxes. One-size-fits-all reduction in the amount of your taxable income. Itemized deductions applied to medical expenses, mortgage interest, charitable donations, etc.
Attention needed! Tax credit can be either refundable or non-refundable.

Check here whether you meet the criteria set by the International Revenue Service (IRS).

Standard deduction and itemizing are two different tax deduction kinds; however, they are an either/or choice. The exact amount of standard deduction depends on your filing status. According to new IRS guidance, educators may itemize unreimbursed expenses for COVID-19 protective equipment.

Developing a tax minimization strategy helps in lowering your tax bracket.

  1. Your W-4

Each change in your employment status can be reflected in the amount of taxes you must pay. This is why the W-4 Form is related to finding how to minimize income tax. This IRS form must be completed in order to inform your employer about the amount to reserve from your paycheck for federal taxes.  You can change your W-4 form at any time by downloading it from the IRS website— making the necessary adjustments and giving it to your HR or payroll team. The more allowances you claim on your W-4, the less money will be taken out of your pay to go toward taxes.

If you received a large refund last year and would rather have that money in your paycheck throughout the year, simply reduce the withholding of your taxes from your employer. You can use the IRS Withholding Calculator to see how to go about it.

  1. 401(k) Savings

Investment in 401(k) savings is a viable option for both self-employed and regularly employed individuals. A 401(k) savings account might be offered by your employer, whereas self-employed individuals can open their own 401(k). This account is usually used as a tax-reducing investments plan for money set aside for retirement. Benefits that come with it include flexible spending accounts, educational assistance programs, adoption expense reimbursements, transportation cost reimbursements, group-term life insurance (up to $50,000), and deferred compensation arrangements.

  1. IRA Account

An Individual Retirement Account (IRA) is among excellent long-term, tax-saving strategies to secure your future. There are two kinds of retirement accounts: Roth and Traditional IRAs. The maximum annual contribution is the same for both kinds, In 2021, you can contribute up to $6,000 for the year, plus $1,000 if you turn 50 by the end of the tax year. With a Traditional IRA, you can contribute pre-tax money that reduces your taxable income, but with a Roth IRA, the opposite is done—namely contributing post-tax money. This means that when you withdraw your retirement money from a Traditional IRA account, it is taxed as ordinary income. In contrast, withdrawing cash for your retirement from a Roth IRA is tax-free.

Look at your current tax bracket and compare it to the one projected for retirement. Then determine which plan amounts to minimizing taxes in retirement, while boosting income.

  1. Health Savings Account (HSA)

An HSA is another tax planning strategy for individuals who are employed but also enjoy a high-deductible health insurance plan. HSAs can be offered by your employer or opened on your own. The money dedicated to such an account is not taxable and can cover medical and dental expenses. HSAs can be used for anyone, depending on your tax return, even for your spouse and children under the age of 19 or 24 (if they are students).

  1. 529 Account

A 529 account is a college savings plan used as a  tax minimization technique. This account is for individuals who want to save money not only for college but even for kindergarten. Since 2019, it has been possible to even cover apprenticeships with this account. Beneficiaries can be your parents, grandparents, or even cousins. And money withdrawals from this account aren’t subject to federal taxes, as long as they are dedicated to educational expenses (e.g., tuition, room and board, textbooks).

Since 529 accounts are state-sponsored, their rules significantly differ. Therefore, it’s crucial to check if a 529 savings plan is offered by your state because some do not deduct state tax. And you’re not obliged to contribute to your own state’s 529 plan—rather, you’re free to choose which state you’d like to invest your money in.

  1. Flexible Spending Account (FSA)

How do you pay fewer taxes and have the necessary medical supplies for your needs? The money you set aside in an FSA account is tax-free. It can be used to cover medical, dental, and everyday expenses of the same type, such as bandages, pregnancy test kits, breast pumps, insulin, etc. You may also decide to spend this money on your qualified dependents. The hitch with an FSA account, however, is that you can lose your money if you don’t spend it within one year. In this case, your employer can give you a grace period of up to 2.5 months (through March 15 of the following year), so that you can take out the rest of the money.

  1. Dependent Care Flexible Spending Account (DCFSA)

Tax minimization strategies also include the DCFSA, which is custom-made for parents and not subject to taxes. The exact plan may vary from one employer to another, but, generally, the DCFSA can cover before- and after-school care, daycare, preschool, and day camps, as well as babysitting and nanny services.

  1. Charitable Contributions

You may deduct charitable contributions of money or property made to qualified organizations if you itemize your deductions.

How tax-deductible donations work depends on where and how you donate. You can deduct up to 60% of your income through charitable contributions and 100% if the contributions are in cash; although, sometimes you might be limited to 20%, 30%, or 50%, depending on the organization. Be careful to donate only to tax-exempt organizations, as described by section 501(c)(3) of the Internal Revenue Code.

You can easily verify an organization’s status with the IRS Exempt Organizations Select Check tool.

  1. Municipal Bonds

Municipal bonds—used for capital expenditure—are debt securities assigned by a state, municipality, or county in order to fund public projects (namely road and bridge construction), as well as parks and schools. Interest paid on municipal bonds is usually tax-free on a federal, state, and local level, which makes them an attractive investment opportunity for individuals in higher tax brackets.

  1. Long-term Capital Gains

Long-term capital gains include stocks, mutual funds, bonds, and real estate, all of which can be subject to favorable taxing. A tax planner or an investment advisor can help you determine when and how to sell appreciated or depreciated securities to minimize gains and maximize losses. For instance, tax-loss harvesting is a tax minimization strategy that consists of selling an investment that has lost value and replacing it with a similar one. It’s then possible to use the investment sold at a loss to balance gains, which means that the investor can simultaneously restore their previous position and mitigate the severity of the loss.

  1. Start a Business

Sometimes, the most lucrative action is to go solo. Health insurance premiums are available to self-employed individuals when specific requirements are met. You can deduct home office expenses if IRS guidelines are followed. When your business grows large enough for you to afford employees, the Setting Every Community Up for Retirement Enhancement (SECURE) act offers tax incentives to employers who join multiple-employer plans and provide retirement options for their employees. In this way, you offer your employees a chance to minimize their taxes in retirement.

  1. Claim Tax Credits

Tax credits can help you set up a safety net. The Child Tax Credit, for example, can secure you with $3,600 per child. You can also save money with the American Rescue Plan, adding up to $2,500 per student for tuition, books, and other school needs during the first four years of college. And the Adoption Tax Credit covers adoption expenses up to $14,440 per child (in 2021).

Pros & Cons

You might have a lot to digest before deciding which combination of tax planning examples is right for you. In the table below, you can review the list of pros and cons of the most common tax strategies.

Pros Cons
Traditional IRA (TIRA) Tax-deferred growth: no taxes on gains, until withdrawals for retirement. Low maximum annual funding and early withdrawal penalties.
Roth IRA (RIRA) Withdraw contributions tax-free, without penalties. Income limits:  for instance, in 2021, the income limit for single filers equals $140,000.
401(k) plans Offered by employers: high contribution limits are an advantage over TIRA and RIRA. Penalized 10% for early withdrawals before the official retirement age of 65.
Municipal bonds Generally safe investment, with low default risk. Detroit bankruptcy in 2013.
Tax credits Immediate financial relief for low-income taxpayers. Bulky bureaucracy, inefficient during the COVID-19 pandemic.

Conclusion

We have presented an overview of tax-efficient strategies related to the question of how to avoid paying taxes. You can choose between 12 different strategies, depending on your current needs and wants. Bear in mind, however, that most tax-related decisions you make now will have consequences in your retirement. That’s why the last part of our tax advice has mostly revolved around the pros and cons of tax-advantaged retirement accounts.

FAQ

What is the purpose of tax planning?

The purpose of tax planning is to minimize one’s tax liability—the total amount of tax debt owed to a taxing authority. What matters most, however, is to choose the best way to reduce taxes from our tax minimization tips.

How much can I donate to charity for taxes?

The Coronavirus Aid, Relief, and Economic Security (CARES) act—an economic stimulus package designed to mitigate the consequences of COVID-19—has made it possible to deduct up to $300 in charitable donations for taxpayers who don’t itemize their deductions. Those who prefer itemizing can deduct between 60% to 100% of their gross income, depending on whether they donate cash or gifts.

Who can donate to charity for tax purposes?

Despite the view that tax avoidance is akin to the lack of social responsibility, donating to charity represents a tax minimization strategy that demonstrates the tax benefits of giving. You can be a philanthropist, but you should first check if the organization you donate cash or non-cash property to is a qualified recipient and if you have the proper documentation that the IRS requires.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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